<<<<<<<<<<< Mat should recruit someone to do an online LBO seminar, 'money for dummies,' or do it himself. I"ve said everything I know about this, which isn't much.
mbs
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Several years ago, William Hummel posted a description of money to the newsgroup sci.econ, which I thought was pretty good, but I'm no expert. At the risk of confusing things even more, here is his post.
-- John K. Taber
From: wfhummel at pacbell.net (William F. Hummel) Newsgroups: sci.econ Subject: An Essay on Understanding Money Date: Fri, 06 Jun 1997 20:14:32 GMT
UNDERSTANDING MONEY
I confess to a fascination with money -- acquiring it, to be sure, but also in understanding what it is and how it works. Money plays a pivotal role in the lives of individuals as well as in the economy as a whole. Yet its complexities are such that no one can be totally free of misconceptions about it. Furthermore, the role and workings of money are constantly changing through innovation and evolution. Concepts that are true today could be obsolete tomorrow. I wrote this essay as much to help crystallize my own thoughts as I did for publication. It deals with only a few basic ideas. But I think it can help others who also are struggling to gain a better insight.
The money I am talking about is fiat money, not commodity money. The distinction is important. Commodity money is simply a certificate of ownership of some valuable commodity like silver or gold. It has an intrinsic value because one can demand delivery of the commodity for the certificate. Fiat money is a creation of government that has no such simple meaning. The government can issue fiat money at trivial cost in any amount. That makes it far more difficult to understand. Commodity money is no longer in general use. We should avoid being misled by concepts that have lost their validity since the adoption of fiat money.
Definition of Money
Money has no simple definition, and there is disagreement as to what instruments should included. For this essay, I take the liberty of defining money as any financial instrument that is widely accepted as payment in a transaction on a same-day basis, plus the reserves of the banking system. This is more inclusive than the definition of M1 by the Fed, which comprises only checkable deposits and currency held by the public. It includes two large pools: money market mutual funds (in M2) and consumer credit available through bank-issued credit devices. Note that it excludes what is often called "near money", debt securities with short term maturities such as T-bills. Such securities can often be used in direct transactions, but that usage is not widespread. More often, they must first be liquidated, i.e. converted into checkable deposits. All fiat money is basically credit money, meaning that there is both a creditor and a debtor associated with every dollar. Even a dollar bill is formally a liability of the Federal Reserve Bank.
Money can be viewed as a stock or a flow. As a stock, its main features are how it is created, what controls its quantity, and how its value is preserved. Money as a stock is less complex and easier to understand than as a flow. Not surprisingly, the concepts are less controversial. As a flow, the focus is on the dynamics of money and the interactions between various sectors of the economy. Any number of closed circuits can be defined. I will briefly discuss what I see as the three most important. The first I call the fiscal circuit. It comprises the reciprocal flow of funds between the government and the private sector. There are two other important circuits, both of which are larger than the fiscal circuit. What I call the industrial circuit comprises the principal activity of the private sector. It includes the flow of household income into consumption and savings, the investment in production that provides the consumer product and the spendable income. What I call the financial circuit is an enormous flow of funds in financial instruments that is largely independent of the real economy.
The Creation of Money
The story of money properly begins with the monetary base. This is money the Fed creates when it buys securities, mainly Treasury debt, from the public for its own portfolio. It pays for the bonds by creating a deposit at a Federal Reserve Bank for the seller’s own commercial bank. The transaction is the equivalent of what is sometimes described as "printing money". That derogatory term, however, masks the fact that it is an essential first step in the creation of the money supply. The newly acquired funds become reserves against which the bank can make commercial and consumer loans. Each dollar of reserves can support a multiple in loan dollars in our fractional reserve banking system. In short, the Fed monetizes debt to provide the reserves that the banking system needs to expand the money supply. The process is ultimately limited by the reserve ratio requirements the Fed imposes on the all depository institutions.
Reserve Ratio Requirements
The reserve ratio requirement limits a bank’s lending power to some fraction of its demand deposits. The current rule allows a bank to lend 90% of such deposits, leaving a reserve of 10% to cover possible withdrawals by its depositors. Since inflow and outflow are normally random and tend to balance each other, this is usually a sufficient margin. There is no required reserve for other bank liabilities, such as savings accounts or certificates of deposit. The rules, although set by the Fed, are constrained within certain limits by the banking laws of Congress.
The "money multiplier" in its basic form is simply the reciprocal of the required reserve ratio. It is sometimes used to indicate how large the credit money supply may become, given the total reserves of the banking system. As we will see, the money multiplier is little more than an after-the-fact observation of the multiple. The reason is that the required reserve ratio actually has little to do with constraining the size of the money supply. The Fed does not directly target either the money supply or the reserves that support it. Instead its focus is on the price of money, which it controls through the leverage it gains from the reserve ratio requirement.
Controlling the Price of Credit
Banks must show compliance with the reserve ratio requirement every other week or face penalties. That creates an active money market in which banks buy or sell reserves among themselves. The interest rate on these short term transactions is called the Fed funds rate. A bank that is short of reserves can, if necessary, borrow the funds it needs at the Fed’s "discount window". The discount rate is normally set somewhat below its Fed funds target rate, and thus the discount window is an attractive source for needed reserves. However the Fed does not allow free use of the discount window. It expects banks to exhaust their other options first. The Fed steers the Fed funds rate to its target quite effectively through two market-influencing mechanisms - its control of discount lending, and its "open market operations". The latter involves short term transactions for its own account, adding or draining system reserves as needed to balance the supply and demand at its target price.
Why does the Fed control the price of credit money rather than its quantity? The answer is that all past attempts to directly control the money supply have resulted in unacceptably wide fluctuations in its price.
Businesses cannot plan efficiently when the price of credit is subject to large and unpredictable changes. As a result of the Fed’s focus on price, the money supply will vary with demand. It expands or contracts according whatever factors influence private sector borrowing. The Fed must provide the reserves the banking system needs in its response to the borrowing demand. If it failed to do so, it would lose control of the Fed funds rate, the bench mark for all short term rates. The Fed plays a largely passive role in this regard, doing only what is necessary in the short term to hold the Fed funds rate on target. As the credit money supply increases, the Fed makes outright bond purchases in order to avoid ever larger short term transactions. Those are the bond purchases, mentioned earlier, that increase the monetary base and the banking system reserves.
Limiting the Money Supply
Since the reserve ratio requirement really doesn’t impede bank lending, what prevents a bank from responding to any and all loan demands, and what limits the money supply from growing excessively? The answer to the first question is that each bank must also comply with an equity capital requirement. This is a complex formula that rates a bank’s assets by quality and requires that its own capital exceed a certain fraction of the quality-weighted assets. A bank can get into trouble by creating too large an asset base through excessive lending. A bank with too low an equity/asset ratio will be placed under supervision by its regulator who may demand to approve any new lending. An insolvent bank can lose its charter.
The answer to the second question -- what limits the money supply growth -- is more complex. If a creditworthy borrower is willing to pay the bank’s rate, the bank will normally make the loan even if it must seek the funds after the fact. This is almost standard procedure with large banks. The only defense against the creation of excessive credit money then is for the Fed to increase the price of credit to the point that it slows net demand. But this is like a small rudder on a massive ship. It can take a long time before there is much response to the corrective action. The time lag in the credit market is usually a matter of many months.
Mismanagement of the credit money supply can readily drive the economy off track, towards inflation or recession. The Fed must keep the supply of credit money in reasonable balance with the production of real goods and services -- its principal monetary policy task. That calls for a great deal of knowledge about the economy as well as skill in interpreting the data. The Fed has made its share of serious mistakes over the years, mistakes that often were not obvious until much later.
The Fiscal Circuit
So far the discussion has focused mainly on money as a stock. One of the easier flows to explain, yet often misunderstood, is the fiscal circuit. This reciprocal flow of funds consists of government spending matched by revenues from taxes and the sale of Treasury bonds. The Treasury does not accumulate a surplus in its financial accounts as some state governments do. Rather it maintains just enough bank balances to cover its near term transactions. Thus the flow of funds back and forth with the private sector is essentially balanced at all times. This is true whether the federal budget is balanced or not. The size of this flow will expand with time as government spending increases, but no money is created in the process. That is done by the fractional reserve banking system, augmented by consumer lending through various bank credit systems.
The way the fiscal circuit relates to inflation is rather indirect. It does not involve an excess of money, but rather an increase in its velocity. As noted, any increase in funds spent by the government are always returned through increased taxes and/or bond sales. Those who buy the bonds tend to be net savers, while part of the government spending flows to those who are likely to consume more than save. On balance, then, an increase in government spending will raise the effective demand even though the money supply remains unchanged. If at the same time there is an inadequate growth in the production of goods and services, the effect would be inflationary. However it usually takes an extended period of imbalance between supply and demand to cause a general increase in prices.
There is a link between the government and the private sector via the Fed that deserves mention. That has to do with the government bonds that find their way into the Fed’s portfolio. The Fed receives interest from the Treasury on those bonds, interest that once accrued to the private sector. When those bonds mature, the Treasury redeems them by paying to the Fed their face value. As a result, the Fed acquires a considerable income each year from interest and redemptions. A small portion of the Fed’s income goes to pay for its operating expenses and for member bank dividends. The remainder (about 90%) is rebated to the Treasury. It’s interesting that this link effectively reduces the interest cost on the debt by some small amount.
The Industrial Circuit
Consumer spending accounts for the major part of the GDP. The spending power arises out of household income that is itself the result of labor and invested savings, which provides what is needed by the business sector to produce the consumable product. This very complex circuit is the subject of endless analysis and debate in economics, and is not the point of this discussion. Rather the point is that growth in the economy depends upon an expansion of credit money. It is not necessary to rely soley on the investment of household savings. Many businesses finance their growth with borrowed money, i.e. newly created money that preceeds the production. They do so with the expectation of servicing their loans from profits earned on the new product, after which they can borrow still more.
In a nutshell, that is how the economy expands. The money supply increases right along with the growth. If it did not, the growth would be throttled. The new money created in borrowing is not inflationary under normal conditions because of the additional product that is created. However it can become inflationary if the borrowing costs are so low that consumers, who are also borrowers, are enticed into spending faster and creating more demand than business expansion can support.
The Financial Circuit
The financial circuit, nearly insignificant 50 years ago, has grown to be the largest in terms of money flows. It comprises flows between financial institutions in activities that are largely divorced from industry. The growth of these institutions is to a sizable extent dependent on lending to one another. A considerable amount of new credit money is thus created by the activities in this circuit.
A key feature is the multiple layering of financial assets whose values are based on the capitalization of a future income stream that has no counterpart in industry. A good description of this circuit, referred to as fictitious capital flows by Robert Guttmann can be found in his book, _How Credit Money Shapes the Economy_.
Some Lingering Questions
1. Aside from currency held by the public, can a significant amount of money really sit idle in a way that serves no worthwhile economic purpose? If so how?
2. Considering the amount of money created for speculation in the financial circuit, is the total money supply significantly larger than it needs to be for the real economy?
3. Since the money supply grows through the banking system’s support of the private sector economy, and the fiscal circuit does not itself create money, what relation if any does the growth rate of the money supply have to the budget deficit when government spending is increasing?
Recommended Reading
_Financial Institutions and Markets_, by Meir Kohn, McGraw-Hill, 1994
_How Credit-Money Shapes the Economy_, by Robert Guttmann, Sharpe, 1994
_The Money Market_, 3rd edition, by Marcia Stigum, Irwin, 1989
_The Federal Reserve System, Purposes & Functions_, 8th edition, Board of Governerors of Fed, 1994
_Secrets of the Temple_ , by William Greider, Simon & Schuster, 1987
_The Bankers_, by Martin Mayer, Dutton, 1997
_Horizontalists and Verticalists_, by Basil Moore, Cambridge Univ Press, 1988
William F. Hummel June 6, 1997